Financial Stability Review – March 2006 Developments in the Financial System Infrastructure
3.1 Crisis Management Arrangements
Last year, the Council of Financial Regulators conducted a review of crisis management arrangements in the Australian financial system. The Council is a non-statutory body whose members include the Governor of the Reserve Bank of Australia, the Secretary to the Treasury, the Chairman of the Australian Prudential Regulation Authority (APRA) and the Chairman of the Australian Securities and Investments Commission (ASIC). Among other things, the Council serves as a forum for ensuring that appropriate co-ordination arrangements are in place for dealing with actual or potential instances of financial instability.
The Council's review endorsed many of the arrangements currently in place for dealing with distressed financial institutions, although it did identify some areas in which co-ordination arrangements could be improved. The review also identified the potential difficulties that could arise in the event that trouble in a financial institution could not be resolved via supervisory intervention, and APRA moved to close the institution.
Under the Banking Act 1959, depositors in a failed deposit-taking institution have first claim over the assets of the institution. The Act, however, does not provide a mechanism for giving depositors in a failed institution access to their funds on a timely basis. Similarly, while policyholders with claims on general insurance companies typically have a senior claim over the assets of a failed general insurer, there is no mechanism for claims to be paid in a timely way.
In the Council's view, significant delays in making payments to depositors and policyholders could complicate management of the failure. Further, such delays are likely to create pressure on the government to step in and perhaps provide a greater level of protection than is set out in the relevant legislation. One consequence of this would be an erosion of market discipline, as depositors and others come to expect similar action in the future.
This likely pressure on the government to support a failed financial institution, despite the relevant banking and insurance legislation setting out clear procedures for regulators when closing failed institutions, reflects, in part, community attitudes. A recent survey by the Bank (see below) suggests that the bulk of people either think that their deposits are guaranteed, or that the government would step in to make sure that their deposits were repaid in full, or in part, in the event of a financial institution's failure. Similarly, half the population believes that money owed to them by a general insurer is either guaranteed or that the government would step in to ensure that it was paid either in full or in part. These views have no doubt been reinforced over the past decade or so by the various government responses to the troubles at the State banks of Victoria and South Australia, Pyramid Building Society, HIH Insurance and United Medical Protection Limited.
The Council's review recommended that, rather than relying on ad hoc government responses, there was merit in establishing formal arrangements – a Financial Claims Compensation Scheme – to provide retail depositors and policyholders with timely access to their funds in the event of closure of an authorised deposit-taking institution or general insurer. In the Council's view, such a scheme would make it easier for the government to take a hands-off approach in situations where that is appropriate, and is consistent with strengthening market discipline in the Australian financial system. In addition to recommending that the government consider a Financial Claims Compensation Scheme, the Council undertook to improve crisis management arrangements among its members, and also recommended that APRA's ability to respond to troubles in a general insurer be strengthened.
The Council's review was sent to the Treasurer in August last year. The Treasurer subsequently asked the Council to consult with the finance sector regarding its proposals. A round of consultation has been completed, with eight submissions received. These submissions are currently being considered by the Council.
3.2 Survey of People's Attitudes
As noted above, the Council has been of the view that a significant proportion of the Australian population expects that the government would take some action to protect people with claims on a failed institution that was subject to prudential regulation. There has, however, been little formal testing of this view. Given this, the Bank recently contracted Roy Morgan Research to conduct a telephone survey of people's attitudes regarding what would happen if a financial institution were to fail. The survey was conducted in mid January and early February, with 1,232 people aged 18 years and over being interviewed. Respondents were asked whether they think that funds in their main deposit account are guaranteed. Where respondents were uncertain, or said that their deposits are not guaranteed (or guaranteed by the institution itself), they were asked questions about how likely it is that the government would step in to ensure that deposits are either repaid in full or in part. A set of similar questions was asked about claims on general insurance companies. The main results are summarised in Table 14.
Of the respondents, 60 per cent were of the opinion that either there is a guarantee (22 per cent) or that it is likely (or highly likely) that the government would step in to ensure either full or partial repayment of the funds in their main deposit account. Only 10 per cent were of the opinion that their main deposit account is not guaranteed and that, in the event of a failure, the government is unlikely to step in. The remaining respondents were unsure as to whether there is a guarantee, or unsure if the government would step in.
When people were asked how quickly they were likely to get their money back under a guarantee or if the government stepped in, relatively few (6 per cent) thought they would get it back within a week, with almost two thirds of respondents indicating it was likely to be at least a month. As with a number of other questions, many people were unsure, or could not provide an answer.
The responses did not vary greatly across age or profession, although there was a slightly greater tendency for those with tertiary education and those below 55 years of age to believe that their deposits were not guaranteed, but that the government was likely to step in to ensure full or partial repayment.
The most notable difference across States was a greater tendency for people in Victoria to respond that their deposits were guaranteed or that the government would bail them out (66 per cent, compared with 57 per cent in the other States). This difference is likely to reflect the responses to the problems at the State Bank of Victoria and the Pyramid Building Society in the early 1990s, and supports the view that past government actions have reinforced the perception that the government will protect depositors.
As part of the survey, people were also asked to identify the supervisor of banks, building societies and credit unions from a multiple choice list (Table 15). The most common answer was ‘other/can't say’ (36 per cent) followed by ‘Reserve Bank’ (28 per cent). Only 14 per cent correctly said that APRA was the supervisor, just slightly more than the number who thought the supervisor was the Australian Bankers' Association.
Compared to deposits, there is greater recognition that claims on general insurance companies are not guaranteed. Despite this, the view that the government was likely to step in to ensure that claims on general insurers were paid either in full or in part was widely held. These views no doubt partly reflect the recent experience with HIH Insurance, where it was demonstrated that claims on general insurers are not guaranteed but that the government may step in.
Overall, the results confirm that there is a widespread view in the Australian community that the government will take some action to protect depositors (and, to a lesser extent, policyholders in general insurance companies) although clearly not everyone is of this view. Another notable aspect of the results is the large number of people who answered ‘don't know’ or ‘can't say’ to the various questions, suggesting considerable uncertainty as to the exact nature of the current arrangements. This uncertainty extends to whether or not there is a guarantee, who would provide it, who is the supervisor, and how quickly the government might step in and provide access to funds in a failed financial institution. Finally, the results also suggest that past actions have had an impact on current attitudes.
3.3 Avian Influenza and Business Continuity Planning
Over recent months, considerable effort has been devoted to contingency planning for a potential avian influenza pandemic. At the government level, the Council of Australian Governments (COAG), at its meeting on 10 February, agreed to develop an Australian Influenza Pandemic Prevention and Preparedness Action Plan (the National Action Plan) by mid 2006. The plan will bring together nationally consistent measures which aim to prevent avian influenza coming into Australia. It will also identify a co-ordinated rapid response in the event of a pandemic developing. To assist in planning for such an outbreak, numerous working groups have been established covering areas such as health, essential services and public information. The focus of one of these working groups is on ensuring that people have access to their financial resources. COAG has agreed to test the National Action Plan in a domestic exercise later in 2006.
Within the finance sector, APRA is currently seeking to confirm that the business continuity plans of financial institutions cover scenarios such as the loss or unavailability of staff and the contamination of facilities at institutions. APRA has issued prudential standards on business continuity management and is currently engaging with the larger institutions and industry groups to confirm that pandemic planning receives appropriate attention. The Reserve Bank is also reviewing its preparedness for a possible avian influenza pandemic, given the Bank's important role in Australia's payments system and financial markets, as well as its responsibilities for the provision of currency and banking facilities for government.
3.4 High-risk and High-yield Investments
Over the past 18 months, ASIC has increased its surveillance of property-related investments offering high yields. ASIC has been concerned that many retail investors have been attracted to these investments without fully understanding the underlying risk that they are assuming – a state of affairs not helped by some misleading advertising and the poor quality of disclosure in some prospectuses. Accordingly, ASIC has taken steps where appropriate to require improved disclosure and stop misleading advertising. In addition, in February this year, ASIC issued a draft policy statement which seeks to promote better standards of disclosure in prospectuses through the use of plain and direct language and a reduction in the excessive amount of legal and financial detail that can conceal the critical information that investors need to know.
ASIC is also concerned about the incentive structures for some financial advisors, which have potentially encouraged inappropriate advice to some retail investors. This issue has been highlighted in the recent failure of the Perth-based property financier and developer Westpoint Group. Westpoint raised much of its funding for property development by issuing promissory notes in amounts of $50,000, limiting the need for detailed disclosure. These promissory notes were purchased by a large number of retail investors, many of whom appear to have done so on the recommendation of financial advisors, often with borrowed funds. In turn, many of these advisors were receiving very high commissions from Westpoint to promote its schemes. ASIC is monitoring financial advisors' handling of complaints by affected investors.
The financial planning industry itself has been considering ways to help reduce the conflicts of interest that arise from advisors seeking to act as a source of independent advice, while at the same time accepting commissions. Following two years of preparation, the Financial Planning Association of Australia, the major professional body for financial planners, recently announced that over the next two years its members will adopt a range of principles for managing conflicts of interest. Importantly, these changes should result in financial planners disclosing any ongoing commission that cannot be characterised as an advice fee agreed to between the client and planner.
3.5 General Insurance Reforms
As highlighted in previous Reviews, APRA is strengthening its prudential requirements for general insurance companies. A major aim of these changes, which address some key recommendations of the HIH Royal Commission, is to provide a clearer picture of insurers' reinsurance contracts. Under the new standards, reinsurance arrangements must be disclosed to APRA annually and prior approval must be sought for limited risk transfer arrangements, or so-called financial reinsurance. Among other changes, general insurers will be required to provide a business plan confirming their ability to meet future capital requirements, and senior management must provide an annual declaration of their institution's financial information. Insurers will also need to appoint approved actuaries to prepare an annual financial condition report, which itself will be reviewed by an independent actuary. APRA-regulated general insurers must comply with the new standards from 1 October 2006.
3.6 ‘Fit and Proper’ Requirements
On 2 March, APRA announced new standards aimed at enhancing the calibre of board directors, senior management, and certain auditors and actuaries of APRA-regulated financial institutions. In essence, these ‘fit and proper’ standards require institutions to evaluate the fitness and propriety of key personnel – both prior to their appointment and thereafter on an annual basis. While the onus is on the regulated institution to ensure that key personnel meet minimum acceptable standards, APRA reserves the right to remove unfit persons in positions of responsibility if the institution is unable or unwilling to do so. The new requirements have been harmonised, where possible, with ASIC's ‘fit and proper’ requirements, and are in line with international benchmarks.